InformationWeek

December 8, 1997

Taking Stock: Nightmare At Cabletron

A disappointing quarter for the networking supplier is just another in a series of blows that should concern investors

By William Schaff

colleague of mine has a colorful phrase for describing technology -- "high tech, high wreck." He recently used it when talking about Cabletron Systems, a leading supplier of networking equipment, including intelligent hubs, switches, and adapter cards, as well as network-management software.

On the morning of Dec. 2, Cabletron pre-announced a shortfall in its fiscal third-quarter earnings, and the share price promptly declined by 32% during the day. The fiscal quarter ended Nov. 30, and consensus earnings per share (EPS) had originally been estimated at 39 cents per share. When the final tally is completed, the company expects a more accurate figure to be 8 cents to 12 cents per share -- a significant discrepancy.

This shouldn't be a complete surprise, as the company already disappointed in an earlier fiscal quarter. InformationWeek readers may remember Cabletron's production problems launching its SmartSwitch 6000 due to component issues. But since the end of the fiscal first quarter, which ended May 31, some positive appreciation in share price was attributable to a variety of factors: the recovery of technology stocks in general, the hope of a new management team led by new CEO Don Reed, and the prospect of eliminating production problems to meet strong new-product demand. Something obviously went wrong.

What was not anticipated was a slowdown in demand for Cabletron's new products. Since the initial production problems were not immediately remedied, customers decided to defer purchases until new switching products by 3Com and Bay Networks were introdu ced. Now Cabletron had to compete head-to-head with all three of the major networking companies, including its primary nemesis, Cisco Systems. The end result was a nightmare. In order to compete for market share, selling prices had to come down. Despite Cabletron's aggressive pricing posture, Cisco continued to increase its market share leadership, especially in the LAN switching market, at Cabletron's expense.

Back at headquarters, Cabletron committed to a major acquisition strategy in an attempt to expand its international presence. The company announced its acquisition of Digital Equipment's former networking business for $430 million. The business was generating revenue of more than $500 million per year, but very little in the way of profits. Digital's networking revenue represents roughly a third of Cabletron's annual revenue base. Interestingly, about 40% of Digital's revenue is generated through indirect sales channels, mostly international.

As most IS managers are aware, Cabletron has always bee n known for its aggressive domestic direct sales force. I would not be surprised to see a clash in cultures leading to a substantial increase in sales personnel turnover if the sales slowdown is material and longer-lasting. Despite what looks like an attractive valuation for the deal, Cabletron is buying a declining business with fading technologies. Throw in the integration issues, and it's hard to imagine that the new management team won't be negatively affected.

Fiscal third-quarter 1998 revenue will come in between $330 million and $340 million, and earnings will include a pretax charge of $25 million to $30 million. Inventory write-downs may be one-time charges, but they still count as a loss of shareholder value. Expect a sharp contraction in gross and operating margins. Gross margins are likely to drop to the 40%-to-49% range from their previous 57% level. Operating margins will likely range from 15% to 19%. With a longer sales cycle and declining sales prices, Cabletron may be hard-pressed to earn $1 per share in 1998. There may not be much more downside left in the share price below $16, but there are too many fundamental questions for me to commit new money. However, at these valuations a takeover of the company isn't out of the question.

William Schaff is chief investment officer at Bay Isle Financial Corp. in San Francisco, which manages the InformationWeek 100 Stock Index. You can reach him at bschaff@bayisle.com .

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